The Pain of Zero Interest Rates

February 21, 2012

With such small returns to be had from the nearly riskless T-bills, cautious household investors find they must either settle for almost nonexistent returns or accept greater risk in their portfolio. The pain caused by the Fed's policy begs the question, then, of why rates are so low, says John H. Makin, a resident scholar at the American Enterprise Institute.

In an uncertain atmosphere for investors, more people are placing cash in the U.S. Treasury because of its assumed safety -- excess demand drives down rates Treasury has to offer.

The lack of viable alternatives further exacerbates this demand; the volatility of the U.S. stock market and its disappointing returns over the last decade largely eliminate it as an option.

Finally, concerns about a double-dip recession and the debt crisis in Europe discourage potential investors from moving into riskier assets.

These factors cause capital to flow to secure assets such as the Treasury and insured deposits. Unfortunately, the low returns offered by these investments is damaging to households that had planned for greater income from maturing nest eggs.

According to the Case-Shiller Home Price Index, home prices are down by more than a third since 2006.

The loss of wealth from this drop in housing values totaled $8 trillion on U.S. owner-occupied real estate alone.

This impairs cash-strapped families even further, as many are stuck with mortgages that outstrip the value of the house.

Additionally, the diminished value of the home often loses the family a potential source of credit, as borrowing against the home is no longer an option.

Many are calling for the Fed to raise rates so that they can gain a greater rate of return on near-riskless investments. However, the consequences of such an action would far outweigh the benefits.

This would increase the cost of the government's interest payments on its debt to about $280 billion and stock prices would fall even further as investors find a reasonable rate of return with no risk.

Higher rates would cause the housing market to flounder again and the resulting stronger dollar would cripple exports.

Source: John H. Makin, "The Pain of Zero Interest Rates," American Enterprise Institute, February 15, 2012.